Debt-Equity Choice
Playing Games with Taxes and
Incentives
Types of Debt Financing
•
•
•
•
1. Bank loans
2. Leases
3. Commercial Paper
4. Corporate Bonds
Bank Loans
• Line of credit
– An arrangement between a bank and a firm that requires the bank to
quote an interest rate, typically for a short-term loan, when the firm
requests the loan. The bank authorizes the maximum loan amount
when setting up the line of credit.
• Loan commitment
– An arrangement that requires a bank to lend up to a maximum
prespecified loan amount at a prespecified interest rate at the firm’s
request as long as the firm meets the requirements established when
the commitment was drawn up. There are two types of loan
commitments:
• Revolver, in which funds flow back and forth between the bank and the firm
without any predetermined schedule. Funds are drawn from the revolver
whenever the firm wants them, up to the maximum amount specified. They
may be subject to an annual cleanup in which the firm must retire all
borrowings.
• Nonrevolving loan commitment in which the firm may not pay down the
loan and then subsequently increase the amount of borrowing.
Leases
• A debt instrument in which the owner of an asset, the
lessor, gives the right to use the asset to another party,
the lessee, in return for a set of contractually fixed
payments.
– Operating lease: An agreement, usually short term, allowing
the lessee to retain the right to cancel the lease and return the
asset to the lessor.
– Financial lease (or capital lease): An agreement that generally
extends over the life of the asset and indicates that the lessee
cannot return the asset except with substantial penalties.
• Leveraged lease (asset purchase financed by a third party),
• Direct lease (asset purchase financed by the manufacturer of the
asset), and
• Sale and leaseback (asset purchased from the lessee by the
lessor).
Commercial Paper
• Commercial paper is a contract by which a
borrower promises to pay a prespecified amount
to the lender of the commercial paper at some
date in the future, usually one to six months.
• This prespecified amount is generally paid off by
issuing new commercial paper (rollover).
• Typically only available to very large companies
with very high credit ratings.
• These contracts are typically traded in public
markets and carry very low interest rates.
Corporate Bonds
• Bonds are tradable fixed-income securities.
• Always have a face amount of $1,000.
• Nearly always have semi-annual coupon payments.
– Coupon rate equals the sum of the two semi-annual payments
divided by 1,000.
– If the coupon rate is 6% the bond pays $30 every six months.
The 6% represents (30+30)/1000.
• Generally issued at with a coupon rate so that the bond
sells for $1,000 in the open market. This is known as
selling at “par.”
• The initial coupon rate is typically set by the syndicate
desk of the investment bank, which issues the bonds to
its (largely institutional) clients.
Deciphering Bond Quotes
• Bond prices are quoted per $100 of face
value (that is 1/10th of their true value).
• A bond sells for par if its quoted price is
100.
• A bond sells at a premium if its quoted
price is above 100.
• A bond sells at a discount if its quoted
price is below 100.
Quotes and Accrued Interest
• Bond prices are quoted net of accrued interest.
• Accrued interest is the amount of interest the
current owner has “accrued” since the last
coupon payment.
• If the accrued interest on a bond is $4, and the
quote is $98, then it will cost you $102 per $100
of face amount you buy.
– In other words a single bond will run you $1,020.
Calculating Accrued Interest
• Corporate bonds accrue interest on a 30
day/360 day year rate.
• Why? Because it has always been so.
– Actually, due to the fact that bonds have been
around a lot longer than the calculator.
– Go ahead try to divided say 6.25 by 365 and
then multiply by 14 by hand.
Accrued Interest Calculation
• Formula
– Coupon payment of $C.
– Last payment at date t0.
– Today is date t.
– Accrued Interest = C(t-t0)/180.
• Note that half a year has only 180 days!
What About the 5 or 6 “Extra”
Days?
• So you noticed a year has more than 360 days.
What to do?
• Since all months are assumed to have 30 days
this means that the accrued interest on August
31 and September 1 will be the same.
• Example: Bond pays coupons on January 15
and July 15.
– On March 15 two months have passed and the
accrued interest equals C(60/180).
– Even February is assumed to have 30 days! On
March 31 the accrued interest is C(75/180) and on
April 1 it is C(75/180).
Secondary Market in Corporate
Bonds
• The secondary market for corporate debt is largely a
broker-dealer market.
– Secondary market makers off to buy and sell particular bonds.
– Quoted prices are better thought of as “ads” saying a dealer is
here and ready to trade the bond.
– To get a price at which you can trade you need to actually call
the market maker. Yes, as in pick up a telephone and call.
• A few corporate bonds are also traded on exchanges
(see the New York Bond Exchange listing in the WSJ).
But the market is limited to very small retail orders,
generally of 10 bonds or less.
• Most corporate bonds are not actively traded anywhere.
Bond Covenants
• Equity holders who control the firm can
expropriate wealth from bondholders by
making assets more risky, reducing assets
through the payment of dividends, and
adding liabilities.
• Virtually all debt contracts contain
covenants to restrict these kinds of
activities:
Asset Covenants
• Seniority and collateral provisions ensure each
debt instrument’s position in line should
bankruptcy occur.
– Senior debt must be paid in full prior to the junior debt
receiving funds. Junior debt must be paid in full prior
to the preferred shareholders.
– Secured debt has a lien on a physical asset, the
collateral. (Think car loan or home mortgage.)
• If the firm does not pay the secured debt on time the debt
holders can repossess the collateral. If selling the collateral
does not pay the claim in full the secured debt holders
become unsecured claimants for the remaining funds.
• Their place on line, with the rest of the firm’s claimants,
depends on the set of contract provisions.
Dividend Covenants
• Prevent the firm from effectively
liquidating, handing the funds to the
shareholders, and declaring bankruptcy.
• Helps guarantee the bond holders receive
their funds prior to the equity holders.
Financing Covenants
• Prevents the firm from issuing new debt
that has seniority over the currently issued
debt.
– Not all debt has this protection!
– On occasion investors have seen the value of
their bonds plummet when a firm issues new
debt that is either senior to or has parity with
(a.k.a. pari passu) their bonds.
Sinking Fund Covenants
• Require that a certain portion of the bonds be
retired before maturity.
– A typical sinking fund on a 20-year bond might ensure
that 24% of the bonds are retired between years 10
and 20.
• The company must establish a bond sinking
fund, which is to be used to meet the principal
payment when the bond matures.
– The cash is often deposited with an independent
trustee.
Theory: The Cost of Debt
Financing
1. ANNOUNCEMENT EFFECTS
– What is the information revealed by announcing a
debt issue?
2. AGENCY COSTS
– Debt in the capital structure induces a distortion of
investment decisions (deviations from NPV rule).
•
•
Reject projects with positive NPV
Accept projects with negative NPV
3. BANKRUPTCY COSTS
– What are the costs incurred in the process of
resolving financial distress?
Announcement Effects
• Stock prices reaction to the announcement of a debt
issue is as follows:
– Non-bank debt: no impact.
• Implies that such debt issues are neutral in terms of the information
conveyed to the market.
– Bank debt (renewal) positive: Equity value increases by about
1.9%.
• Good news. The fact that the bank is willing to make a loan
indicates that the firm’s prospects are better than the market
previously thought.
– Convertible debt: negative: Equity value decreases by about
2%.
• Bad news. The issuance of this type of debt indicates the firm’s
future prospects are not as good as the market previously believed.
Agency Cost of Debt
• When a firm has risky debt in its capital
structure, maximization of shareholders’
value may differ from maximization of
firm’s value (sum of equity and debt).
– When evaluating a project,
• shareholders emphasize its upside potential,
• bondholders are concerned mainly with its
downside risk,
• from the point of view of the NPV you should look
at both.
$
Equity Payoff
Debt Payoff
Amount Promised
Bond Holders
Profits
Risk Preferences
• Notice that the equity holders like risk and
the bond holders dislike risk.
• Encourages management to select riskier
projects, even if they have lower or
perhaps negative present values.
Example
• Firm owes the bond holders $100.
• The firm can invest in project Green or Gold.
Each project costs $100 in PV to implement.
• Project Green pays $101 in PV for sure.
– This is a positive PV project with an expected profit of
PV = $101-$100 = $1.
• Project Gold pays $25 in PV half the time, and
$125 half the time.
– This is a negative PV project with an expected profit
of .5($25)+.5($125) → PV = $75 - $100 = -$25.
If Firm Maximizes Equity Value
• Project Green
– Firm earns $101. Equity gets $101 minus the amount
owed debt ($100) for an expected profit of $1.
• Project Gold
– If the firm earns $25, it is bankrupt and the equity
holders get zero.
– If the firm earns $125, the bondholders collect the
$100 due them. The equity holders get $125-$100 =
$25.
– Expected equity payoff equals .5($0) + .5($25) =
$12.5.
$
Equity Payoff
Debt Payoff
Expected Gold
Payoffs
High Gold
Payoffs
$100
Low Gold
Payoffs
Green Project Payoffs
$100
Profits
Intuition
• For the equity holders:
– Heads equity wins, tails debt loses.
– If the firm does well the profits go to equity.
– If the firm does poorly, the losses go to the
bond holders.
– For a given expected payoff, the more risk the
better.
What to Watch For
• Project switching
– Firm says it will pursue low risk cash flows in
the future.
– After issuing debt the firm switches to projects
with high cash flow risks.
• Empirical evidence
– Only seems to be a problem when firms are
close to or in bankruptcy.
– Look for this in firms with low quality high yield
debt or distressed debt.
Bankruptcy Costs
• If a firm is in financial distress, it may not
be able to meet its debt obligations.
– This may lead to default.
• What are the possibilities?
– Informal reorganization. Often called
Workouts.
• Bankruptcy
– Formal reorganization (Chapter 11), or
liquidation (Chapter 7).
Why the Bankruptcy Code?
• Why the government says we need a formal bankruptcy
procedure:
– To facilitate lending, creditors need legal rights to claim
corporate assets.
– To protect companies from excessive, inefficient liquidations.
• Why we may not need the current structure:
– In theory enforceable private contacts should allow lenders to
claim assets. What is needed is an efficient mechanism for the
verification of the lender’s claim followed by the swift transfer of
assets.
– Excessive and inefficient liquidations are unlikely in any setting.
If the firm is worth more “alive than dead” the parties have every
financial incentive to keep it going. It is more likely “excessive
and inefficient liquidations” are political speak for “layoffs in my
voting district.”
– Current code often delays creditor’s claims, and makes contract
provisions either totally unenforceable or effectively
unenforceable.
Bankruptcy Costs
• Direct costs:
– Legal and administrative costs; losses for forced
liquidations
• Indirect costs:
– Lost business opportunities due to financial distress:
• Lost customers
• Suppliers want cash
• Managers may leave
• Why do shareholders care?
– Because they can lose their stake in the firm
– Because it makes debt much more expensive
Tax Advantages of Debt Revisited
• Tax deductibility of interest payments makes debt
desirable at the corporate level.
• What about personal taxes for investors?
– Interest payments → typically taxed at the personal tax rate
– Equity income → dividends taxes at personal rate
capital gains taxed at lower rate
• Overall, equity income is typically taxed at a lower rate.
– Implication: after adjusting for risk, investors will require a higher
return on debt than equity.
• Tax advantage of debt at the corporate level.
• Tax advantage of equity at the personal level.
Implications for Capital Structure
• Firms will want to use debt financing up to the point
where they eliminate their entire corporate tax liabilities,
but they will not want to borrow beyond that point.
• With uncertainty, firms will pick the debt ratio that weighs
the benefits associated with the debt tax shield, when it
can be used, against the higher cost of debt increases
where the debt tax shield cannot be used.
• Firms with more non-debt tax shields are likely to use
less debt financing.
• There exists an optimal, firm-specific capital structure
– Optimal debt level will:
• Increase with expected cash flows
• Decrease with risk of cash flows
• Decrease with available deductions
Firm
Value
Vmax
D
 
V
High ACD
Low ACE
Low Tax Benefits
optimal
1
D/V
Low ACD
High ACE
High Tax Benefits
Debt Policy In Practice
• Most CFOs do not care about:
– Taxes
– Bankruptcy costs
– Comparable firms
• It seems that the most important factors
that determine a firm's capital structure
are:
– Financial Flexibility
– The cost of debt
How D/E is Determined
• Structure is more often changed by changes in
the amount of equity, not in the amount of debt.
– Since debt issues are infrequent relative to the daily
revaluation of the stock in the marketplace.
• The most important reasons why firms issue
(repurchase) stock are:
– Dilution in EPS,
– Market under/overvaluation
Equity – More or Less
• Less: Share repurchases.
– Stock prices react positively to the
announcement of a share repurchase.
– Cash payout: equivalent to dividends;
– Signal of undervaluation
• Methods: Tender Offers vs. Open Market
Purchases
– For Tender Offers: Average increase in the
value of the firm’s stock equals 17%.
Equity: More, New Issues
• Stock prices tend to react negatively to the
announcement of a new equity issue.
– General cash offers occur after a significant run-up in
an issuer’s secondary market price.
• Announcement of an equity issue is met by a
negative price reaction.
– However, the negative price reaction tends to
decrease during economic expansions.
• Cancellation of an announced issue is met by a
positive stock price reaction.
• Frequency of equity issues tends to rise during
economic expansions.
Shelf Registration
• To simplify the procedures for issuing securities, the SEC currently
allows for “shelf registration.”
– Firms with a stock value greater than $150 million can register stock or
bonds, then issue them anytime in the next 2 years.
• Allows management flexibility in when to issue securities (no waiting
period between filing with the SEC and sale).
• Asymmetric information period likely to be worse.
– Probably why shelf registrations are used more for bonds than stocks
• Firms do not have to name an investment banker in the registration
statement.
– Gives firm more leverage in bargaining wit investment bankers for lower
fees.
• Empirically, issuance costs are lower for shelf registered equity.
Convertible Debt
• A convertible bond gives the holder the right to exchange
it for a given number of shares of stock anytime up to
and including the maturity date of the bond.
• If the holder chooses to convert, bondholders surrender
their bonds in exchange for a given fraction of equity.
– Example: Bond with $1000 face value
– Convertible into equity @ $20 per share (conversion price)
– Conversion ratio: 50 shares per bond
• Conversion premium is the difference between the
conversion price and the current stock price.
• Convertible debt is sometimes callable. This means that
the issuing firm has the option to convert (call for
conversion) the bonds before maturity by paying a price
specified in the contract.
Convertible Bond Valuation
•
Includes:
– The value of a Straight Bond
– Option value
•
Holders of convertibles need not convert immediately. Instead, by waiting
they can take advantage of whichever is greater in the future, the straight
bond value or the conversion value. (This is call option for convertible bond
holders)
At maturity = Max (A, α, ET ) ,
A = bond’s face value ($1,000).
α = conversion ratio.
ET = stock price at maturity.
Max  A,α,ST  
=
A
+

Value of
the bond.
A

αMax  0,ST - 
α


Value of the
call option.
Firm Options
• Callable Bond
– Firm has the option to call the bonds prior to
maturity.
– This is a call option for the firm.
– Firms call bonds when:
• Interest rates decline.
• Their business fortunes improve.
Call Provisions: Investment Grade
Bonds
• Often not callable.
• If callable typical terms are “treasury yield plus
50 basis points.”
– English translation: Discount the remaining cash
flows at the treasury rate plus ½%. That is the call
price.
– Only pays to call such bonds if the bond can be
refinanced at a spread smaller than 50 bps.
• From the “Estimating the CAPM Inputs” lecture: Average
yield spread between treasuries and AAA bonds is 52 bps.
• Essentially call protected from changes in interest rates and
most events involving the company’s fortunes.
Call Provisions: High Yield Bonds
• Typically callable.
• Call schedule for a ten year bond often
follows a pattern like the following if the
coupon rate is C (example 12%):
– In five years call at 100 + C/2 (106).
– In six years call at 99 + C/2 (105).
– In seven years call at 98 + C/2 (104).
– Etc.
High Yield Call Provisions
• Call provision is a bet on both the company’s
future fortunes and future interest rates.
• If the company does well or interest rates fall
substantially it will be able to issue new bonds at
a substantially lower promised interest rate.
– This will make calling the bonds attractive.
– If paid in full the bond may be worth say 110 due to
the high coupon rate and now promising company
fortunes but can call it at just 106.
Why Include Call Provisions
• Signals that management believes the company
will do much better in the future.
• Call provision requires a higher initial coupon
rate if the bond is issued at par (100).
– Must compensate buyers for giving the firm the right
to call the bond.
• For the firm to recoup the higher initial cost it
must do well enough in the future to make
calling the bond worthwhile.
What Firm Types Should Issue
Callable Bonds?
• If management knows the firm’s prospects are
better than the market believes them to be then
such firms should find callable bonds to be cost
effective.
– Pay more now, but know that with high probability will
save later on.
• For firms where management knows the firm’s
prospects are no better than the market believes
them to be, callable bonds should not be cost
effective.
– Pay more now, and later since with high probability it
will never pay to call the bonds.
Terminology: Yield to Call
• Yield to Maturity (YTM)
– Yield assuming it is never called.
• Yield to First Call (YFC)
– Yield assuming the bond is called at the
earliest possible date.
• Yield to Worst (YTW) sometimes Yield to
Worst Call (YWC).
– Yield assuming the bond is called on the date
that produces the lowest yield for its owner.
Quoting Convention
• When bond traders quote yields, they typically
quote yield to worst.
– Assumption is that the firm in trying to minimize its
cost of capital will end up calling the bond at the date
that minimizes the bond’s yield.
• Even YTW will, on average, overstate a bond’s
expected return since it assumes all payments
are made on time.
– Some bond’s do not pay off on time reducing the
expected return from the promised return.
Callable Bond Yield Example
• A bond pays semi-annual coupons of $6
per $100 of face value. The bond comes
due in ten years. The call schedule is as
follows:
Year
Call Price
6
106
7
105
8
104
9
103
Price Call Date Yield Relationship
At Issue
Price
6
Call Date
7
8
9
10
100
12.70%
12.47%
12.31%
12.19%
12.00%
105
11.54%
11.43%
11.35%
11.30%
11.16%
110
10.46%
10.45%
10.46%
10.47%
10.37%
115
9.44%
9.53%
9.61%
9.68%
9.63%
YFC
YTW
YTM
Key:
Price Call Date Yield Relationship
In Five Years
Price
6
Call Date
7
8
9
10
100
17.75%
14.25%
13.13%
12.60%
12.00%
105
12.35%
11.43%
11.15%
11.04%
10.68%
110
7.34%
8.78%
9.29%
9.57%
9.44%
115
2.66%
6.29%
7.53%
8.18%
8.28%
YFC
YTW
YTM
Key:
Price Call Date Yield Relationship
In Seven Years
Price
Call Date
8
9
10
100
15.85%
13.36%
12.00%
105
10.50%
10.55%
10.03%
110
5.53%
7.91%
8.17%
115
0.89%
5.42%
6.42%
Key:
YFC
YTW
YTM
Yield to Worst, Call Dates, and
Time to Maturity
• Because the call price is typically less than
100 + semi-annual coupon
– Low market prices result in a Yield to Worst
equal to the Yield to Maturity.
– High market prices result in a Yield to Worst
equal to the Yield to First Call.
– As time progresses the price at which YTW
switches from YTM to YFC declines.
Why the Price YTW Pattern?
• The tradeoff is the call price versus receiving the stream
of semi-annual coupon payments.
• Low market price + receiving the call price in the near
future = very valuable relative to the future coupons.
– Very high rate of return if you buy a bond for 100 and sell it six
months later for 105.
• High market price makes the return from receiving the
call price much less attractive. In this case you want the
future coupons.
– Negative rate of return if you buy a bond for 106 and it is called
six months later for 105.
• As time passes the call price declines and the price at
which the YTW equals the YTM declines with it.
Debt Induced Problems
• Having debt in the capital structure may induce
shareholders to deviate from the NPV rule at
later dates:
– Shareholders may give up positive NPV projects
(underinvestment problem).
– Shareholders may take projects with negative NPV
(excessive risk taking problem).
• The cost of these inefficient investment policies
is ultimately borne by the shareholders.
• When issuing debt, shareholders must consider
these costs as well, and trade them against the
benefits of debt (such as its tax advantages)
Debt vs. Equity
• Share prices react negatively to announcements of equity issues,
and positively to announcement of share buybacks.
• The presence of asymmetric information may induce the firm to give
up good investment opportunities.
• Conflict of interest between short term and long term shareholders.
• Issuing debt is better → Pecking Order Theory of Financing
– Use retained earning first.
– Then use securities that are less sensitive to informational asymmetries,
such as senior debt.
– Then use equity.
• Value of financial slack.
– If a good project comes along you want funds available to take
advantage of it. Issuing debt so that you can no longer borrow may
prevent a firm from making some beneficial investments.
– Project financing may be helpful if it maintains some financial slack for
the firm.
Summary
• OUTSIDE EQUITY
– Costly because of its negative announcement effect.
– Project financing may avoid such a negative impact.
• DEBT FINANCING
– Has positive effects:
• Tax Advantages
• No announcement effect
• Reduces free cash-flow
– Has negative effects:
• Bankruptcy costs
– Distortion of investment decisions:
• Underinvestment.
• Excessive risk taking.
– Role for dividend constraints and bond covenants;
– Use secured debt, convertible debt
• RETAINED EARNINGS
– Good: avoid costs of external financing
– Bad: costs of free cash-flow